The ratings agency Standard & Poor’s has downgraded United States sovereign debt overnight, from AAA to AA+.  They are one of the big three agencies alongside Moody’s and Fitch, so it is a significant and unprecedented step.  There are two obvious questions: Why has the US been downgraded and not Britain?  And, what does it mean for us?

In their statement about the downgrade Standard and Poor’s answer the first question.  Contrary to some early reports, they don’t attach particular blame to any party or ideology.  Their view is essentially that they don’t see the political will to take sufficient action to address the deficit there in the medium term:

When comparing the U.S. to sovereigns with ‘AAA’ long-term ratings that we view as relevant peers–Canada, France, Germany, and the U.K.–we also observe, based on our base case scenarios for each, that the trajectory of the U.S.’s net public debt is diverging from the others. Including the U.S., we estimate that these five sovereigns will have net general government debt to GDP ratios this year ranging from 34% (Canada) to 80% (the U.K.), with the U.S. debt burden at 74%. By 2015, we project that their net public debt to GDP ratios will range between 30% (lowest, Canada) and 83% (highest, France), with the U.S. debt burden at 79%. However, in contrast with the U.S., we project that the net public debt burdens of these other sovereigns will begin to decline, either before or by 2015.

Britain’s credibility has always rested on an assessment by the markets and the ratings agencies that people here do accept cuts are necessary.  As I quoted in How to Cut Public Spending, Moody’s specifically credited that as a key reason to maintain our AAA rating before the last election, despite the parties largely avoiding a serious and specific discussion of cuts at that point:

Moody’s assessment that the UK government exhibits a high degree of debt reversibility is supported by the trend over recent months towards an apparent consensus among the public that fiscal retrenchment (including cuts in expenditure) is both inevitable and desirable.

Thankfully the people we are borrowing so many billions from understand that most Britons do want to deal with the deficit, they trust that the irresponsible “no cuts” brigade are a small minority.

It will be Monday before we have a clear idea of what this means for Britain.  There are two key questions.

First whether the ratings agency is essentially following markets which have already priced in that US debt is a lot more risky than it used to be.  Or whether this is another event like the Lehman’s collapse or the events in Greece that alters investors’ perceptions of what is safe quite drastically, and therefore causes a lot of disruption in world markets.  We will find out on Monday.

The second question is whether or not the fact in itself that this debt is no longer unambiguously rated as AAA will force some institutional investors to move their money.  If all the agencies changed their ratings that would almost certainly be the case.  But if Moody’s and Fitch keep the US at AAA then it might not happen.  Again we will get a clearer picture on Monday.

It still looks like the eurozone’s problems are the biggest threat to the global economy right now.  Italy and Spain’s problems are much more urgent.

I don’t think this should change our policy priorities.  We still need to keep up the fiscal adjustment to maintain our credibility, so that ratings agencies don’t come to the same conclusions about our will to sort out our public finances they have come to about the US.  But also with so many dangers in the international economy we need supply side reforms to strengthen the underlying strength of our economy.  Not more spending, which is generally associated with lower economic growth, but improvements in incentives for people to work, invest and build businesses in Britain.  We can’t leave opportunities like more dramatic cuts in business taxes on the table and we need to look at the deeper reforms the 2020 Tax Commission is studying.

Financial markets across Europe and the United States have been in turmoil this week as fears have grown about the ability of the Spanish and Italian governments to repay their debt and the prospect of a double-dip recession in America. The London Stock Exchange’s FTSE100 index closed at 5,393 on Thursday 4th August, down from a high of 5,912 on Monday – a fall of 8.8 per cent. Mr Knapp of Barclays Capital highlighted the impact of worries about the American economy:

When the outlook for the US is good or OK, people find it much easier to deal with the problems in Europe

The problem is that lenders are losing confidence in the likelihood that their money will be repaid. The reason governments need to borrow so much money in the first place and that lenders are nervous about lending further vast sums is, of course, because governments have failed to get a grip on spending. Instead of keeping spending prudent during the expansionary years of the credit cycle, the governments now in trouble are those which ran deficits instead. When the financial crisis of 2008 hit, unemployment rose, meaning spending forcing spending to follow suit, while profits and incomes fell bringing taxation revenues down with them. The strength of these factors varied between countries but so did the starting points.

Government budget balances, % of GPD (OECD)

Germany, Australia and Sweden ran budget surpluses in 2007; Greece, Italy and the United States all ran significant deficits. In 2010, the US and Greece ran deficits of approximately 10 per cent of GDP. Italy, with its huge existing debt, retained a deficit that by today’s standards counts as moderate (but would have been seen as dangerous before 2008).

Germany, Australia and Sweden had swung into deficits by 2010, too, but their borrowing was at a much lower rate. This has affected growth rates. Those three countries grew by 3.4, 2.9 and 4.5 per cent in 2011 but Greece’s economic output shrivelled by further 2.9 as Italy and the US grew by just 1.1 and 2.6 per cent. The correlation between large budget deficits and low growth is stark.

Sadly, Britain is in the high deficit, low growth group. As Sean O’Grady reports in the Independent, the head of the Office for Budget Responsibility has warned that the economy is unlikely to meet its already weak existing forecast of 1.7 per cent:

As a simple matter of arithmetic, in order to get to 1.7 per cent now you’d be looking for quarter-on-quarter growth rates of 1 per cent in the second and third quarters of 2011, and there aren’t many people out there expecting that.

If the Government want to revitalise the economy, they need to start implementing the cuts that have been talked about so much. Simpler, lower taxes. Lighter, smarter regulation. Reliable, stable money. These are the things an economy needs to grow, not ‘stimulus’, borrowing and taxes.

Figures released on Tuesday show the economy grew by just 0.2 per cent in the first quarter of this financial year. Initial estimates are usually revised up, subsequently. In addition, the Japanese tsunami and earthquake, the Royal Wedding, unseasonal heat and the delay in counting Olympic ticket sales have all been used by the ONS to save ministerial blushes for the disappointing figures. Is there really much of a macroeconomic impact from warm weather, for example? Wouldn’t spending simply be switched from heating and sweaters to ice-creams and shorts? But even ignoring all that the number is a serious disappointment, if not an unexpected one. Growth should be a lot higher and the Government’s continued high spending and failure to get to grips with supply side reforms is getting in the way. Ed Balls, the Shadow Chancellor of the Exchequer, voiced concern about the low figure:

“The economy has effectively flatlined for nine months and this is very bad news for jobs, living standards, business investment and for getting the deficit down”

At the same stage following the 1990-91 recession the economy was growing 5 times as fast as it is now. Fast growth following a recession should be expected, as depressed asset prices and wage levels tempt firms to make use of the capacity freed up during the contraction. Despite the rhetoric surrounding supposed cuts, the Government has continued to increase spending which has meant it is still employing staff, occupying offices and purchasing the supplies that would normally now be in the process of being reallocated into more productive and efficient use by price signals and market forces. With the Government still spending over half of the economy’s output, the room for the private sector to generate economic growth is much smaller than back in the early 1990s when the Government’s share was closer to 40 per cent.

Quarterly economic growth, 2007-11 and 1990-94

Research has shown that an economy with a 10 per cent higher share of GDP being consumed by government will suffer from growth rate approximately 1 per cent lower than otherwise. But it’s not just aggregate spending figures which have conspired to fetter the nation’s economic prospects. The cumulative effect of two decades of gold-plated regulations from Whitehall and Brussels and tougher planning restrictions have also served to restrict the economy’s ability to adapt to changing conditions and preferences in society. Cities of London and Westminster MP, Mark Field, has highlighted the need for loosening the restrictions in the economy:

“As a matter of urgency we need to start implementing micro or supply side initiatives designed to free up small and medium size enterprises (SMEs). We have to ‘think the unthinkable’ and cut the regulatory and taxation framework which hinders many SMEs”

Fortunately, what needs to be done is not terribly unthinkable. On the regulatory front, hack back the thicket of over-zealous box-ticking regulations in town planning, health and safety and labour markets. Unwinding those regulations back to a sensible framework is no mean task but it is certainly not unthinkable. Similarly daunting is the task of overhauling Britain’s enormously over-complicated tax code. The 2020 Tax Commission , a major joint project with the Institute of Directors, is taking on this task and will produce a root-and-branch overhaul of the system in early 2012. But there are things that can and should be done right now, too.

Contributing to the ConservativeHome Growth Manifesto from London think tanks, Matt Sinclair, Director of the TaxPayers’ Alliance, said we should cut National Insurance, cut Corporation Tax faster and axe the 50p income tax band. Twelve other organisations contributed further pro-growth reforms that should give the Government plenty to be getting on with. Some, such as the European Trade Union Institute’s Duncan Weldon, at a BBC Radio 4 debate, have criticised the manifesto for not being a response to slow growth because we always propose such policies. The reason for this is simple. Supply side reforms always boost growth and we are always in favour of growth and prosperity, not just when the economy has been particularly wrecked by profligate spending, burdensome taxes and a mountain of debt.

Fortunately, the political momentum for tax cuts is growing and Mayor of London Boris Johnson called on the Government to scrap the 50p rate and cut National Insurance in yesterday’s Daily Telegraph:

“You’ve got to look at ways of stimulating growth now, and certainly I think you should look at National Insurance, you should look at ways of stimulating consumption confidence in the market”

Politicians from across the political spectrum who recognise the need for economic growth should join the Mayor of London in backing our proposed tax cuts.

Central government spending soared by 4.9 per cent to £52 billion in June 2011, up from £49.5 billion in June last year according to Office for Budget Responsibility (OBR) figures. The higher than budgeted figures led to an increase in public sector net borrowing from £13.6 to £14.0 billion. Tax receipts also rose, but not as rapidly as government spending. Nida Eli of the Ernst & Young Item Club said:

“The government still has a very long way to go in order to meet its target of reducing borrowing by £20bn this year. With nine months to go it needs to reduce borrowing by more than £2bn a month compared with last year’s figures.”

The figures show a large gap between the terms of public debate on spending and the facts. With the official Consumer Price Index of inflation at 4.2 per cent in June, spending is still rising even after adjusting for inflation. The so-called cuts simply aren’t happening and that is dangerous for two reasons: high public spending is holding back the economy and the enormous borrowing means we risk runaway debt service costs and, ultimately, a sovereign debt crisis.

Athenian austerity riots

Britain has a debt problem. It’s not as bad as Greece’s; our official debt is approximately 80 per cent of the economy compared to 140 per cent for Greece. The average ‘maturity’ of our debt, the length of time left before we are obliged to repay it, is also much longer meaning that in each year a smaller proportion of our debt needs to be refinanced with new debt. But the scale of our borrowing problem is very similar to Greece’s and, unless we tackle our massive borrowing problem, our debt problem might soon look a lot more like Greece’s than we’d like it too.

The Government must act now to reverse the rise in spending and bring borrowing back down not just to the Government’s own tame budgeted proposals, but lower still to create room for tax cuts and growth in the private sector. The credibility of the Government’s spending plans is at stake and if capital markets stop believing the Government’s promises to keep spending under control they will become more nervous about the possibility that their loans might not be repaid. That means they will demand a higher rate of interest to make up for the increased risk. This in turn means higher government spending which can easily turn into a downward spiral (of higher spending on interest and worries about higher spending leading lenders to raise interest rates) into the kind of sovereign debt crisis now engulfing Greece.

Bold cuts to public spending are needed to avoid following that example. Britain’s taxes are already too high and too complicated. The only answer to the borrowing problem is in spending control. But reducing spending will boost the wider economy too, not just the public finances. More public sector spending means more resources being allocated by the public sector according to politicians’ priorities and bureaucrats’ convenience rather than consumers’ actual wants and needs. And that leads to slower growth in the economy and a less prosperous society. While they are always difficult at first for those whose jobs are lost or whose incomes are reduced, over time spending cuts lead to growth in the private sector and the economy as a whole.

The Forum of Private Business (FPB) have released a new report, the latest in their quarterly Referendum series of member surveys.  This one is about the cost of compliance with regulation from health and safety to employment law and PAYE and National Insurance.  The FPB represent small firms who often particularly struggle with these requirements and incredibly regulations are costing the UK’s 1.17 million micro, small and medium sized employers an average of £25,500.

That means huge amounts of staff time that could have been spent growing the business, creating new job opportunities.  Billions spent on external help to deal with the more complicated rules, and make sure they are getting things like tax right.  The most onerous areas are health and safety, employment law and tax.

Health and safety regulations need to be closely scrutinised.  Any that have been in place for more than five years should be assessed to see if they have altered the trend in that area, has it actually made people healthier or reduced accidents?  The FPB found the cost of health and safety regulation is still rising which is incredible with manufacturing in long term decline as a share of employment.  It is also a particular problems for small but growing firms as the cost becomes a lot greater when they employ their fifth person, and face new requirements.  Do we want to put small companies off growing like that?

In employment law politicians really need to appreciate that what they think will “protect” jobs will often actually just stop people getting hired in the first place.  Small businesses in particular need flexibility to limit the financial risk when they take someone on.

Reducing the complexity of the tax system is difficult but vital.  That’s why we are running the 2020 Tax Commission which is going to set out a radical plan to reform taxes to improve incentives and make the whole system a lot simpler.

Too often calls to cut sharply cut red tape remain vague and therefore unproductive.  Hopefully with the 2020 Tax Commission and other projects we can start to set out concrete proposals to make Britain an easier place to grow a small business, and create new opportunities.

The Treasury and Office for National Statistics have released the latest public sector finances statistical bulletin with figures relating to April and May. For all the talk in the media of ‘savage cuts’, total current expenditure rose from £50.6 billion in May last year to £51.7 billion in May 2011. Meanwhile, current receipts rose from £35.1 to £38 billion. After net investment is added, that leaves net borrowing at £17.1 billion, down from £19.3 billion.

Government spends £4 for every £3 raised in tax

These figures show that the need for a fiscal retraction remains overwhelming. The UK borrowed over £17 billion pounds in May alone because the £38 billion raised in tax was not enough to fund Government spending. The events unfolding in Greece show that the greater risk does not lie in the Coalition Government’s timid cuts being too hard but instead that they’re too small. The British economy desperately needs tax cuts and tax simplification but it also needs to close the huge deficit these figures reveal.

Once social benefits and interest charges are stripped out, remaining current expenditure rose only slightly, from £32.5 billion in May 2010 to £32.6 billion in May 2011. This shows that the Government is showing restraint that would be, in a more benign environment, admirable. But for a government that is spending more than £4 for every £3 it can raise in taxation, it simply isn’t good enough.

The reforms set to be announced by George Osborne in his Mansion House speech tonight, aiming to ring-fence retail banking, are an incomplete response to the financial crisis, and if the Government aren’t careful they could be actively unhelpful.  While the details are very complex, there are some simple issues that taxpayers should be aware of in judging if reforms are going to make it more or less likely that bankers come begging to them for a handout again.

Talking to ITV News about changes to financial regulation

As I told ITV news this lunchtime, separating out retail and investment banking can be actively dangerous.  To understand why, imagine you separated them completely into relatively safe retail banks and relatively risky investment banks.  The retail banks would still be able to take risks.  Banking is an inherently risky activity as you often lend for the long term and borrow for the short term.  Research has even found that banks with investment banking divisions can be more reliable as they are more diversified.  Northern Rock didn’t have an investment banking arm, after all.  Alex Tabarrok, one of the authors at the Marginal Revolution blog, sets out why that could be the case here:

Proponents of the Glass-Steagall Act argued that separating commercial and investment banking would increase the safety and reduce bank and customer conflicts of interest.  Neither of these arguments bares close scrutiny here.  At the most basic level, it is clear that many securities (stocks and bonds) are less risky than are loans.  Security investments are also liquid and publicly observable.  Liquidity lets banks quickly rebalance their portfolios to avoid runs, and public observability improves the efficiency of bank monitoring by depositors and bond holders.  Even if all securities were riskier than all loans, forbidding banks to invest in securities could increase bank risk because of the benefits of diversification (see Macey 1991).

If a bank is told that it is a safe, retail bank which the Government can’t possibly allow to fail then that will encourage them to take risks.  We will be offering the retail banks a very explicit heads you win, tails we lose, bet.

It isn’t clear yet how much risky activity will be contained within the retail part of the banks, as we don’t know the Government’s definition of retail and investment banking.  But Robert Peston has written about one definition, and the extent to which major risks are still contained within that notional retail banking sector:

A recent suggestion by HSBC – which would base the break-up on a new accounting standard differentiating a bank’s trading activities from traditional banking (in the jargon, those assets valued on an accrual basis would be in the ring-fenced retail bank, and those marked to market would be outside) – would see some 60% or 70% of a bank inside the ring-fence.

Now some bankers argue that HSBC’s proposal would tend to keep taxpayers far too exposed to potential bank losses – since, in practice during the recent crash and recession, losses for banks on HSBC’s definition of retail banking have been massively greater than investment banking losses (by a multiple). For example, HBOS’s insanely loss-making loans to property businesses would have been inside the ring fence, on HSBC’s definition.

It could be that we do need to carve out a safe space for retail depositors.  It is far from clear that the Government is doing that though and half measures could be the worst possible outcome.

There are two missing ingredients so far.  The first is ensuring that bondholders bear the risk when they lend to banks.  The decision to give them a free pass, as we did in the bank bailout, creates huge moral hazard.  If someone lends money to a company, and it goes bust, they should lose it.  Otherwise there is no incentive for lenders to insist that executives at the banks are careful about the risks they take on, and be careful about only lending money to sound institutions.  Andrew Lilico has led the charge on this arguing that bondholders should be bailed in, rather than banks being bailed out, and he wrote about that for ConservativeHome.

The other thing they need to do is look at global regulations that are increasing the systemic risk to the financial system.  As that regulation becomes more and more homogenous, the result is a kind of monoculture which is far more vulnerable to disease.  When something goes wrong everyone has the same vulnerabilities and tries to respond in the same way, becoming a huge danger to the world economy.  There is a lot more on this in a short research paper we released with the Legatum Institute.

For all these shortcomings, there was some very good news at the speech.  The Government is going to auction Northern Rock as soon as possible.  We need to get our money back, and we need to get the Government out of the business of investing in banks.

The recovery has been distinctly lacklustre recently. Recovering from a financial crisis is hard and, as higher spending tends to mean lower growth,  an economy straining under the heavy load of spending at 46 per cent of national income was always going to struggle. Construction in particular seems to have had a hard time.

There is good news though.  We aren’t facing the kind of dismal prospects that they are in the United States on employment. More people are getting jobs and businesses are planning to hire lots more over the Summer. Reuters reports that staffing firm Manpower thinks the market is holding up well and the time is right for necessary public sector job cuts:

Small and medium-sized companies plan to step up hiring over the summer, a survey by staffing firm Manpower showed, raising the chances that private firms will make up for jobs lost due to the government’s spending cuts.

“We’ve been warned for such a long time to expect large scale public sector job cuts in central government, but in our experience that is just not happening,” Mark Cahill, Managing Director of Manpower, said in a statement.

“If the government really intends to make the large-scale redundancies initially suggested, ministers must realise that the longer they wait to start this process, the harder it will eventually become,” he said.

“We’re now confident that job creation in the private sector, particularly among SMEs, can now fill the gap created by job losses in the public sector,” he added.

Steve Hawkes at the Sun adds a quote from the stockbroker Investec:

We may be going through a soft patch in the recovery now, but employers are looking to hire.

Our relatively liberal employment laws mean that businesses feel confident to employ people as the economy recovers. If only we had the kind of supply-side reforms we need to get Government off the backs of families and businesses, a real plan for growth. Combine stronger trend growth, with a private sector that has shown it will create lots of jobs, and robust welfare reform, and everyone can enjoy more opportunities and greater prosperity. It’s an exciting opportunity.

On Monday Duncan Bannatyne wrote about the life of a modern entrepreneur in the Financial Times. Among other things he discussed the overwhelming amounts of regulation and bureaucracy that blight today’s businesses, and the failure of banks to provide loans to those looking to start new firms.

The myriad of poorly thought out, badly written and obstructive regulations and laws that govern those who try to start – and grow – a business is a huge burden and can hold otherwise sound businesses back. The Business Secretary has made it his job to cut regulation but action needs to follow the rhetoric.

In addition to less regulation, lower taxes are needed to keep those businesses that do succeed in the country. If we are to return to the nation of entrepreneurs we once were, the Government needs to encourage entrepreneurial spirit by doing less, making the environment less daunting. The lack of capital to start up a business in the current economic climate is a real concern but the reluctance of some banks to provide finance for viable businesses is only part of the problem. Governments must be wary of directing the banks to finance more loans while also demanding banks build up their reserves to guard against another crisis.

The Government has for too long patronised entrepreneurs with Regional Development Agencies and by attempting to pick winners. Further government ‘assistance’ is not what the business community needs. The only way the government can truly help is to cut taxes and regulation. A good example is the North East  – it’s now heavily reliant on taxpayers’ money, with 64 per cent of GDP in the region made up by public spending. But it hasn’t always been like this; it was previously an industrial powerhouse, with the likes of George Stephenson creating huge industries at a time of low tax, less regulation and a much smaller state. The standard of living of poorer people at the time was dragged up with high wages, and people flocked from all over to work there. The place was a hive of innovation and entrepreneurship.

Bannatyne makes some good points in his piece, although his call for greater government assistance for entrepreneurs should mean getting out of their way so they can create jobs and wealth. Although he summed up the folly of grant-giving best on Dragon’s Den, as this clip shows.

In an interview with the Times this morning, the OECD chief economist Pier Carlo Padoan said that “if there is not so good news on the growth front” the Government might have to reconsider its spending plans.  Ed Balls has got very excited about that and said “it’s now time George Osborne listened to wise advice” and reconsidered the fiscal adjustment.  Unfortunately for the Shadow Chancellor, the OECD has made clear that, on the current data, they think that planned spending cuts are necessary.  Just yesterday they published their Economic Outlook, and said:

“The current fiscal consolidation strikes the right balance and should continue in line with the government’s medium-term plan to eliminate the deficit, while allowing the automatic stabilisers to work.”

There hasn’t been a rush of new economic data overnight which has led to a Damascene conversion at the OECD.  They’ve clearly been asked a question by the newspapers about what their recommendation could be in certain, currently hypothetical, circumstances.  If Ed Balls appeals to their authority then he is going to have to accept that the institution currently backs the fiscal adjustment.  Otherwise he is going to have to set out why exactly the organisation is wise today but was foolish yesterday.

Zoe Williams writes in this morning’s Guardian about Canada’s fiscal consolidation of the 1990s. She believes that we should not learn lessons from their experience, as we are in a very different situation. In our book How to Cut Public Spending, we devoted a substantive section to why there are very important lessons to learn from Canada. But fair enough, debates to be had and all that.

Until Ms Williams says this:

“To edge back a step, our deficit was nothing like Canada’s either. Theirs had been rising steadily since 1974, and had got to 70% of GDP. Ours was 30% before the financial crash, a figure that is manageable, almost respectable.”

It’s very difficult to engage in genuine debate about how to tackle the deficit if one side of the argument constantly confuse it with debt. Influential journalist Johann Hari did the same a little while back on his blog and in an article for GQ. He quietly corrected the mistake, but even then Matthew Sinclair still comprehensively deconstructed his argument.

The headline of today’s Guardian piece includes the line “Let’s start denying this deficit properly”. Denying a deficit of the size we have now is frightening. By implication, the author wishes to deny a deficit of 70 per cent of GDP, which is… well, what’s a stronger word than frightening?

To be fair, this glaring error has been corrected on The Guardian’s website. It has, however, run in the print edition, meaning the piece misinforms a lot of readers. But let’s accept a mistake was made, and the correction stands. A quick look at the Budget 2011 document shows us that even if the author meant debt, ours will be 69.7 per cent of GDP next year. Around the size Ms. Williams says Canada’s was before their fiscal consolidation. Our problems cannot be blamed solely on bailing out the banks either, though we should be trying to get our money back. Spending was racked up to unsustainable levels and whoever won the last General Election would be taking action to cut back.

The TPA has a clear view on the course of action needed to cure our fiscal woes. We’ve produced countless research papers and notes on what the problems are and how we can solve them. We’re also willing to engage in robust debate on the issue. That’s difficult when arguments on the other side are littered with mistakes like these.

Last week we held a brilliant event bringing together different groups opposing HS2.  Speakers from the Green Party, the RAC Foundation, the Countryside Alliance, AGAHST – the federation of action groups against HS2, and the TaxPayers’ Alliance explained why they thought the project was a bad one.  If you weren’t able to make it, the video is below the jump, please share it around:

The Transport Select Committee are running a consultation on the scheme and we have submitted evidence to it.  Our submission contains a lot more detail on many of the arguments made at the event.  With the scheme representing very poor value we will continue to press for it to be abandoned.